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Cleveland Clinic to Sell $1B for ARS, Growth

JUL 30, 2008 1:00am ET
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CHICAGO - The prestigious Cleveland Clinic Health System plans to enter the market as soon as next month with a $1.1 billion bond issue that will refund all the system's auction-rate securities and include $500 million in new money to finance regional expansion.

The CCHS finance team is still crafting details of the structure, which will include a mix of fixed-rate debt and variable-rate demand bonds.

JPMorganis the lead underwriter on the deal. Jones Day is bond counsel.

The transaction includes $620 million to refinance all of the system's outstanding ARS. The refunding comes a few months after the clinic purchased a big chunk of the debt after failed auctions prompted interest rates on some of the bonds to spike to 15%. Like issuers across the country, the Cleveland Clinic began experiencing failed auctions on its debt starting in February amid a general credit crunch stemming largely from bad mortgage loans.

In a move that analysts say is increasingly common among higher-rated health care credits, the clinic plans to provide its own liquidity on the variable-rate piece of the upcoming deal.

Proceeds from the $500 million new-money portion of the issue will move the system closer to completing a capital campaign that is expected to total $2.5 billion through 2010.

The Ohio Higher Educational Facility Commission is acting as the conduit issuer, marking its largest bond issue in recent years.

Founded in 1921, the Cleveland Clinic Health System includes 12 hospitals and 18 medical centers, nearly all of which are located in northeast Ohio, where it is the region's largest employer. The clinic maintains a top international clinical reputation that has proved to be one of its chief credit strengths, according to analysts. Its cardiac program has ranked first in the U.S. for the last 14 years, according to the 2008 U.S. News and World Report "America's Best Hospitals" survey.

Moody's Investors Service rates CCHS Aa3 with a positive outlook. Standard & Poor's rates it AA-minus with a stable outlook. Both agencies are expected to release ratings on the new issue in the next few weeks.

"We think they have a really strong business position and that has not changed," Standard & Poor's analyst Martin Arrick said. "They have a pretty well thought out process for figuring out how to expand their footprint in a national and international way, and they're taking the long-term view, which should serve them well."

With annual revenues of around $2.5 billion, the system has another roughly $2 billion in unrestricted cash and investments, and reported 175 days cash on hand as of Aug. 31, 2007. It has "very strong" debt service coverage of seven times, and "favorably low" debt-to-cashflow of 2.7 times in 2006, according to Moody's.

The system expects to price the bonds within the next 30 to 60 days, according to Michael Harrington, the clinic's chief accounting officer.

When CCHS began experiencing failed auctions on its debt earlier this year, some of the interest rates rose as high as 15%, according to a presentation system officials gave to the Ohio Higher Educational Facility Commission in May.

To stem the rising rates, officials decided to take advantage of a "purchase in lieu of redemption" feature of the ARS, and purchased the bonds, Harrington said. The system also bought some additional bonds that were experiencing failed auctions but at lower rates, and currently holds about $330 million of the auction-rate debt in its treasury, he said.

Much of the rest of the ARS had provisions restricting maximum interest rates to 6% or below in case of failure. Harrington declined to detail how much in additional interest rate costs the system incurred so far this year, saying the additional costs were "minimal."

The system's auction-rate debt was insured by Ambac Assurance Corp., Financial Guaranty Insurance Co., MBIA Insurance Corp., and Financial Security Assurance Inc.

The clinic's decision to purchase its failing ARS amid the collapsing market was one of several tools used by issuers with enough capital to quickly limit exposure until they could craft refunding transactions, noted Moody's analyst Lisa Martin.

The Cleveland Clinic will provide its own liquidity on the variable-rate bonds in the upcoming transaction, using money from its investment pool to pay for tenders if necessary. Providing its own liquidity allows for a "more efficient and flexible structure, and leverages CCHS' strong balance sheet," Harrington said.

For those credits able to do it, providing their own liquidity also allows issuers to avoid rising liquidity fees amid the credit crunch, and avoid the turmoil in the bond insurance market, where rating agencies have downgraded or put on watch nearly all former triple-A rated monoline bond insurers.

Self-liquidity is becoming more common for highly rated health care credits like the Cleveland Clinic, Martin said.

"Generally we are seeing more health systems at their rating level issue variable-rate bonds that are backed by self-liquidity," she said. "And at the double-A rating level, not all but many health systems would have the financial expertise and liquidity to be able to start a program of that nature."

With unrestricted investments at $2.1 billion by mid-2007, CCHS likely has ample liquidity to cover possible tenders on the upcoming bonds. But its investment performance has taken a hit over the last six months, Arrick noted.

"Their investment performance has been really soft, like for most credits in the equity markets," he said, noting that the system has lost $100 million over the last six months. "That's not a huge number, as they have $2.5 billion in revenue, but that's what's happening across the sector - they're kind of following the market."

The poor investment performance is unlikely to affect the Cleveland Clinic's credit unless it persists for a long period of time, Arrick added.

CCHS' investment portfolio has been the cause of some concern in the past. In a report issued in November 2007, Moody's cited the system's plan to increase its asset allocation to 33% alternative investments, supplementing 33% fixed income and 33% equity allocations.

"While the strategy anticipates good diversification across asset types and managers, we believe this allocation is very high because of the lower transparency and liquidity typically associated with most of these types of investments," Martin wrote in the Moody's report.

In 2003 Standard & Poor's downgraded the system to A from A-plus due to a poor investment performance that prompted a "precipitous" decline in liquidity levels and bit into the balance sheet. The rating agency has since upgraded the credit twice.

The new-money portion of the upcoming bond sale will be used to finance a number of construction and expansion projects that will inch CCHS closer to completing a capital plan that could require up to $2.5 billion in borrowing through 2010.

The system will use most of the $500 million to finance an expansion of the Hillcrest Hospital and construct a new 82-bed medical tower, as well as two new family health centers in the cities of Avon and Twinsburg. About $40 million in proceeds will be used to finance a new 4,000-space parking garage on the clinic's main Cleveland campus, and the rest of the money will go to a variety of other projects across the health care system's six-county area.

Currently the clinic has $1.42 billion in outstanding debt. Of that, $861 million is floating rate and $559 is fixed rate, Harrington said. About $332 million of the floating-rate debt is hedged in a series of floating-to-fixed rate swaps that expire in 2016, 2030, 2032, and 2036.

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